Lecture 5 - Understanding interest rates Flashcards
What is the concept of present value or present discounted value?
A pound paid to you one year from now is less valuable to you than a pound paid to you today. This notion is because you can deposit a pound today in a savings account that earns interest and have more than a pound in one year.
What happens with the simples kind of debt instrument, a simple loan?
The lender provides the borrower with an amount of funds (called principal) that must be repaid to the lender at the maturity date, along with an additional payment for the interest.
What is discounting the future?
Calculating today’s value of pounds received in the future.
What is compound interest?
Interest is calculated not only on the initial principal but also on the accumulated interest of prior periods.
What is Yield To Maturity defined as?
The interest rate that equates the present value of the stream of payments generated by a debt instrument with its value (price) today.
What is a fixed payment loan (also called a fully amortised loan)?
The lender provides the borrower with an amount of funds, which must be repaid by making the same payment every period (such as a month), consisting of part of the principal and interest for a set number of years.
What is a coupon bond?
A coupon bond pays the owner of the bond a fixed interest payment (coupon payment) every year until the maturity date, when a specified final amount (face value or par value) is repaid.
What is a coupon rate?
A yearly coupon payment expressed as a percentage of the face value of the bond.
How is a coupon bond identified?
The corporation or government agency that issues the bond, the maturity date of the bond and the bond’s coupon rate which is the money amount of the yearly coupon payment expressed as a percentage of the face value of the bond.
What is a discount bond, also known as a zero coupon?
A discount bond is bought at a price below its face value (at a discount), and the face value is repaid at the maturity date. Unlike a coupon bond, a discount bond does not make any interest payments; it just pays off the face value. Examples include the UK and US Treasury bills.
If the coupon bond is purchased at its par value…
The YTM and the coupon rate must be equal.
The current bond price and the yield to maturity are related how for a discount bond and a coupon bond?
Negatively. A rise in the interest rate as measured by the yield to maturity means that the price of the bond must fall. A fall in the yield to maturity means that the price of the discount bond has risen.
What does a higher interest rate imply?
That the future coupon payments and final payment are worth less when discounted back to the present; hence the price of the bond must be lower.
When is the YTM greater than the coupon rate?
When the bond price is below its par value.
What happens when the YTM equals the coupon rate?
The bond price is at the face value.
What is a perpetuity or a consol?
A perpetuity bond has no maturity date and no repayment of principal. It makes fixed coupon payments forever.
